Few disagree that regulatory change in the Netherlands and Sweden will see pension funds increase their exposure to longer-dated bonds. As Chris Newlands finds out, the debate is about how big the shift will be.

When European regulators start revising pension solvency requirements, dealers and issuers tend to sit up and take note. Legislative efforts to increase pensioner protection and decrease exposure to market risk have historically led to large sums of money being directed into bonds.

And activity in the Netherlands and Sweden – which will force pension funds to mark their liabilities to market – looks set to bring more of the same.

Syndicate managers agree that the shift to fair value accounting in the Netherlands (the second largest pension market in Europe) and its proposed introduction in Sweden will sharply increase the volatility of pension scheme liabilities and encourage them to ramp up their exposure to long-dated bonds and derivatives, and become forced sellers of short-dated notes and equities.

If the views of local Dutch investment banks are used as a guide, then more than €120bn-worth of Dutch assets will pass into 30-year paper before the end of next year. Even conservative estimates put the figure at a still considerable €50bn.

At the same time – and although the Swedish market is a lot further away from implementation than its Dutch peer – Nordea believes that Swedish funds would have to buy some Skr165bn (€18bn) of government debt to increase the duration of their bond holdings by just seven-and-a-half years.

“I have no doubt that Dutch pension funds will be massive buyers of duration this year,” says Bas Iserief, head of fixed income at ABN AMRO Global Markets in Amsterdam. “Investors will want to hedge the risk in their long-term liabilities and we expect something like €120bn of funds to flow into 30-year deals – but this could be even bigger. There can be little argument that the new requirements will have a huge impact on yields this year.”

Danish comparison

If the Danish pension fund market, which began marking its liabilities to market in 2001, is used as a marker of how Dutch and Swedish investors might react to fair value accounting, then pension schemes could increase their allocation to bonds by some 40%, while lowering their equity holdings by more than 70%.

In reality, however, this seems unlikely. The introduction of mark-to-market calculations in Denmark came as equity prices began to crash and at the same time as the Danish Financial Services Authority unveiled its traffic-light system – a colour-coded stress test in which funds had to prove they could endure further falls in equities as well as fluctuations in interest rates.

“It is very difficult to see Dutch and Swedish funds moving into long-term bonds and out of equities in the manner the Danish did,” says Jonas Cedergren, distribution head for the Nordic region and the Netherlands at Barclays Capital. “Their move to fair values came at the beginning of an equity fallout and that fallout came just as funds started to increase their exposure to equities. The situation for them was much more extreme.”

Laurent Fransolet, European fixed income strategist at JPMorgan, agrees: “No, we will not see movements like we did in Denmark – not over such a short time frame, at any rate. A bear market in equities triggered the sharp change in Danish asset allocation but, although not stellar, equities are performing well, while interest rates are at absolute lows,” he says. “Times have changed. Three years ago people were worried about their equity holdings regardless of asset and liability questions, but that is not the case any more. Even if funds did want to reduce their equity exposure, right now, there is a good chance they would put that money into hedge funds and commodities ahead of bonds.”

Hedging a priority

The new Dutch financial assessment framework, called FTK, comes into effect at the beginning of next year and funds are anxious that time is running out for them to address duration mismatches. ABP, the €168bn government and education workers fund, and the Dutch Association of Industry-Wide Pension Funds (VB) acknowledge the fact that they must do something to hedge their liability risks soon but both are concerned about interest rates.

Gerda Smits, spokesperson for VB, says: “The move from a fixed to a variable rate means far greater volatility for our cover ratios. We expect to gradually increase the average duration of our bond holdings but current rates are low, which makes such a move expensive. If we hedge against a fall in rates while they are low, we will lose out when rates rise.”

This view is shared by Bart Kuijpers, structured solutions, at BNP Paribas. “A shift out of equities into bonds is definitely the sensible thing to do. But the sensible option is not always the easiest option,” he says. “The problem that Dutch funds have to face is the low interest-rate environment. They are asking themselves why they should pull out of equities and lock into 20 or 30-year bond yields when interest rates might increase in coming years. Approaching the board right now and asking them to increase bond exposure is not an easy task.”

Supply and demand

Another problem, more pertinent for Swedish funds whose currency is not pegged to the euro, is whether the current supply of long-dated domestic government debt is large enough to meet the increase in demand the new regulations could bring. Unlike Danish funds, which also had access to a €170bn domestic mortgage bond market – the second largest in the world, Swedish government issuance is thin. Dutch funds can tap the larger and more liquid euro-market (which may have its own supply problems) but Swedish schemes that want to avoid currency risk are restricted to domestic buying.

“The effect of the solvency reform will be significant,” Nordea says in its research report Solvency Reform in Sweden. “Swedish life insurers hold about one-third of domestic government debt and a simultaneous attempt by several insurers to increase the duration of their domestic fixed-income portfolios would simply drain the market. Empirical evidence suggests that even the very deep and liquid European market for long bonds and interest rate swaps would be affected by large duration-matching deals.”

Jeroen Steenvoorden, director of the Dutch Association of Company Pension Schemes, agrees: “What we really need is a greater supply of euro-denominated, long duration, index-linked bonds. Potential demand for these deals exceeds €400bn but, as it stands, supply is poor.”

Derivatives popularity

However, investors do have the option of tapping the derivatives market. When Danish funds switched to fair value accounting in 2001, the demand for financial structures, such as constant maturity swap (CMS) floors and swaptions, increased considerably and local analysts – in both the Netherlands and Sweden – expect a large number of foreign dealers to flock to their shores touting structured services.

“Funds are gearing themselves up to use overlays, such as swaps and CMS floors, but how confident they are in using such products varies considerably from fund to fund,” says Mr Cedergren at Barclays Capital. “Some investors are ready to start using them but others need a great deal of education and that is a job for the consultants, asset managers and investment banks together.”

Ben Katz, managing director, hybrid capital solutions, at Lehman Brothers, puts it more simply: “In the world of derivatives, this is huge.”

But Mr Kuijpers, at BNP Paribas, believes rising interest rates will dampen demand. “Investors will use derivatives but it is only really the bigger funds that have the capabilities to execute these products,” he says. “The small and medium-sized funds need to put a lot of systems in place before they can start tapping this market. Non-linear products such as CMS floors and swaptions require an enormous change of thinking on the part of pension fund managers. But investors do not like rates at their current levels and, at least for the bigger players, there is definitely no appetite to address mismatches right now.”

Opposing points of view

However, it is the differing views from local or foreign houses about just how much the move to fair value accounting will impact the market that is the real mismatch – particularly in the Netherlands. No one doubts the fact that marking to market will bring increased flows into the fixed income arena, but estimates of just how big those flows will be differ widely between the domestic and non-domestic players.

“Certain banks have been banging on this drum for three years now,” says one official at a non-Dutch investment bank. “Yes, 30-year deals have flattened but it is not because of pension funds in the Netherlands; it is because people are searching for yield.

“If you take the UK as an example, where some 66% of assets are held in equities, you can see that there has not been any large-scale move into bonds despite falling equity markets and the introduction of FRS17. So why should the Dutch behave any differently?”

Mr Iserief, at ABN, however, has no such doubts: “Yield curves will flatten – that I am sure of. For people to say the move to fair values will have limited impact at the long end is rubbish.

“There is no mystery to it – if you have long-dated liabilities then it is convention to buy long-dated bonds and other assets to hedge that risk. The argument is simple.”

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